A 401k loan is a loan that you take out against the balance in your 401k. A 401k loan can be a good way to finance large purchases if you do not want to get a typical loan!
If you have started saving for your retirement (if not, you should), you likely have a 401k with your company or have at least heard the term before. A 401k is essentially a retirement account that is set up by the company you work for. As you contribute to this retirement account, your company will likely match your contributions to some certain amount. This is a fantastic tool to grow your nest egg to prepare you for retirement. As such, you should start a 401k and contribute frequently if you can.
While a 401k is great for your retirement, did you also know that you can get a loan using it as well? That’s right. Some companies offer a plan with their 401k that allows employees to use the balances in their 401k account to take out a loan. These are called 401k loans, and they can be a great tool if you are really in need of cash. Not every company that offers a 401k allows for 401k loan, so make sure to check with your employer first, and then you can start to look into 401k loan rules.
With a 401k loan, you are taking money out of your account to be used as a loan. Normally, when you take money out of your 401k account you get heavily penalized and taxed for it. However, this is not the case for a 401k loan and is one of the reasons that it can be a smarter option for you than withdrawing from your account. In reality, it surprisingly often ends up being cheaper to get a 401k loan from your account then to simply withdraw money before you retire.
Just like any other type of loan, you can use a 401k loan to finance any purchase. While you should not take debt out to make a frivolous purchase of any kind, there are still many other instances where the money from a 401k loan can be used.
One instance could be to make a purchase of a car or some other expensive purchase that might require thousands of dollars to make. If you have a bad credit score and are worried about getting your loan application denied or being faced with high interest rates, a 401k can help to protect you from both of these things. Similarly, if an unexpected expense like a medical emergency arises that you are unable to pay for, getting a loan from your 401k could help make ends meet. Money to make purchases like this can be very hard to come by, especially if you have a poor credit score. Thankfully, your credit score isn't taken into account when getting a loan from your own 401k.
Another situation where a 401k loan could be used would be if you are struggling to make loan or credit card payments on multiple accounts. Oftentimes, payments of these types can be pretty expensive depending on your credit score. They have high interest rates that can make it difficult to consistently make every single payment. Missing a loan payment can make it even more expensive through late fees and additional loan interest. Further, missing a payment can really hurt your credit score and dig you a deeper hole. To prevent this, you can use a 401k loan as a sort of debt consolidation loan. You can take out a 401k loan to help make payments on or completely pay off some of your outstanding debt that charges high interest rates. Your 401k will have fairly low interest rates compared to these other forms of debt, so using this to pay off your other loans and credit cards can not only make payments easier but can make it cheaper for you as well.
I know what you might be thinking; “Debt should always be avoided if it can be, right? If I really need the money, why should I take out a 401k loan instead of withdrawing some of the balance in my account?” This is a very valid question. Intuitively, you would think that withdrawing money from an account would never be more expensive than a loan. However, this is not the case for a 401k loan. Withdrawing money instead of a loan is not only more expensive but can hurt your effort for retirement saving.
Confused? Let’s look at it a little deeper. Let’s use a great example from Fidelity on withdrawing versus getting a loan.
Let’s say you have $38,000 in your 401k account and you need $15,000 right now. If you get a loan, you simply have $15,000 less in your account and have no taxes or penalties to pay. If you instead withdraw $15,000, you take the $15,000 out and pay roughly an additional $9,000 in penalties and taxes. $9,000! That is a huge amount of money that simply vanishes when you withdraw instead of getting a loan. It’s obviously more expensive to withdraw, but what does this mean for your retirement?
If you were to do this at the age of 45, your nest egg balance when you retire around the age of 65 could be almost $60,000 less if you withdrew money instead of getting a loan.
Truly, the difference between withdrawing your money before retirement and getting a 401k loan are tremendous. Not only is it cheaper to get a loan if you need money, but it is also the smarter move for your retirement plan. Keep this in mind the next time you really need money and are considering withdrawing from your account.
The amount of money you can borrow with a 401k loan depends on the plan your company has for your 401k. Typically, your plan will allow you to borrow about 50% of your current balance. However, this cannot be more than $50,000 within 12 months. Unless you need a gigantic sum of money, you should be able to finance whatever purchase or expense you have with a 401k loan.
The loan amount limits with a 401k loan can be another reason to get a 401k loan versus a different type of loan. For example, while you can get one with a poor credit score, a payday loan will typically not let you get a loan larger than $500. While a personal loan will let you take out a sizable loan, you might have trouble getting a loan for tens of thousands of dollars if you have a poor credit score. However, with a 401k loan you can get a loan of up to $50,000 regardless of your credit score.
As with other aspects of a 401k loan, the length of your loan will depend on your company and the 401k plan they have created for you. Loan repayment lengths will vary but typically your loan length will be 5 years.
Your 401k loan is an installment loan, meaning you will repay your loan principal and interest back with equal installments until it is completely paid off. Again, your payment frequency will depend on your plan. The IRS recommends at least quarterly payments of interest and principle until it is paid off, but you can also pay the loan back with monthly payments as well.
While a 5 year loan with a low interest rate should not be too bad to pay off, know that you cannot make contributions to your 401k while you are paying off a 401k loan. Likewise, your 401k loan payments do not count as contributions to your 401k and your company will not match them. Any time you and your company are not contributing to your nest egg is time that is wasted that could have helped grow your retirement savings substantially. Not contributing for 5 years has a much bigger effect on your potential retirement savings down the road if you are 25 then if you were 45, for example. If you are relatively young and are considering getting a 401k loan, take this into consideration.
Unless you think you’ve found your dream job, there is a high likelihood that you will change your job at some point. While rolling over your 401k to a different company’s 401k plan is not that great of a hassle, the waters get a little murkier when you leave your job that you have an outstanding 401k loan with. Basically, when you change your job with an outstanding 401k loan you will need to cough up the money to pay back the loan or otherwise face some heavy taxes.
If your next company has a 401k and they allow you to roll it over, you can roll it over into your new 401k and continue paying the loan back normally. However, if you can't do this and you still have a loan that still needs to be paid from your 401k, you have until the end of the tax year to pay it off, regardless if there are still multiple years left on the loan. Pretty tough right?
If you can’t pay it back, your 401k provider will treat the rest of your outstanding loan balance as money you withdrew from the 401k. Recall that withdrawing money from your 401k causes a huge tax hit and also requires you to pay some money in penalties.
Overall, try not to leave your job with an outstanding 401k loan if you know you won’t be able to pay it off quickly. If you get fired or otherwise can’t do this, try rolling the 401k over to a new job. Otherwise, prepare yourself for a big tax hit along with additional penalties.
Still unsure if a 401k loan is right for you? Let’s summarize and dive into some pros and cons with 401k loans so you can be better informed.